I had pointed to the interest rate policy reversal by Iceland Central bank. There is full chaos there. However, the falling of Iceland was not very well known
WIllem Buiter and Anne Sibert have analysed the Iceland problems in this voxeu piece. The article is a summary of a more detailed paper available here. The analysis points that Iceland model was always problematic and bound to fail:
In the first half of 2008, Buiter and Sibert were invited to study Iceland’s financial problems. They identified the “vulnerable quartet” of (1) a small country with (2) a large banking sector, (3) its own currency and (4) limited fiscal capacity – a quartet that meant Iceland’s banking model was not viable. How right they were.
The duo studies the problems but the report was not made public as it was pretty sensitive. As Lehman collapsed, Iceland’s banks foreign assets and exposure was noticed and rest is history. As things are well known now, Buiter et al have released the paper and it has very useful lessons.
Why it fell?
Our April/July paper noted that Iceland had, in a very short period of time, created an internationally active banking sector that was vast relative to the size of its very small economy. Iceland also has its own currency. Our central point was that this ‘business model’ for Iceland was not viable.
The mistakes made
Couple of mistakes were made worsening the crisis
The decision of the government to take a 75 percent equity stake in Glitnir on September 29 risked turning a bank debt crisis into a sovereign debt crisis. Fortunately, Glitnir went into receivership before its shareholders had time to approve the government takeover
Then, on October 7, the Central Bank of Iceland announced a currency peg for the króna without having the reserves to support. It was one of the shortest-lived currency pegs in history. At the time of writing (28 October 2008) there is no functioning foreign exchange market for the Icelandic króna.
In addition, outrageous bullying behaviour by the UK authorities probably precipitated the collapse of Kaupthing – the last Icelandic bank still standing at the time. The official excuse of the British government for its thuggish behaviour was that the Icelandic authorities had informed it that they would not honour Iceland’s deposit guarantees for the UK subsidiaries of its banks. Transcripts of the key conversation on the issue between British and Icelandic authorities suggest that, if the story of Pinocchio is anything to go by, a lot of people in HM Treasury today have noses that are rather longer than they used to be.
I liked the Pinocchio bit. Despite the policy mistakes, the fall was pretty clear as the large international banking model was unsustainable at the first place. An excellent analysis and if it had been released earlier, Buiter and Sibert would have joined Nouriel Roubini as Doomsayers.
However, they point similar conditions in other economies as well:
Iceland’s circumstances were extreme, but there are other countries suffering from milder versions of the same fundamental inconsistent – or at least vulnerable – quartet:
(1) A small country with (2) a large, internationally exposed banking sector, (3) its own currency and (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap.
Countries that come to mind are:
and even to some extent the UK, although it is significantly larger than the others and has a minor-league legacy reserve currency.
Ireland, Belgium, the Netherland and Luxembourg possess the advantage of having the euro, a global reserve currency, as their national currency. Illiquidity alone should therefore not become a fatal problem for their banking sectors. But with limited fiscal spare capacity, their ability to address serious fundamental banking sector insolvency issues may well be in doubt.
Incidentally, today’s Eurointelligence points Denmark is thinking of joining the Euro as they can’t have their cake and eat it too. By being a member of EU but not adopting Euro will not work forever.
I was also wondering what would have been the fate of India if Mumbai International Finance Centre reportwas actively taken up by policymakers. The idea behind international finance centre is to provide international finance options to both domestic and international companies from Mumbai. This would have implied Indian banking system would have become more international with times. Now, in this crisis out of the 4 conditions for Iceland, 2 would have been applicable to India as well- (2) a large, internationally exposed banking sector, (3) its own currency
The other two i.e. (1) A small country (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap – would have depended on the magnitude of the crisis hitting Indian shores. As current experience shows countries that are large and have spare fiscal capacity are facing the brunt as well.
This does not imply not to have an international finance centre in Mumbai but be prepared for such events as well.